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What made headlines before is now becoming everyday news, that energy companies
are scaling back or leaving energy trading. Some emphasize the shift to "trading
around assets." Anne Ku investigates just what this means.

Trading with
a small t

by Anne Ku

(original version of the 3 page article published
in EPRM April 2003 issue)

Before the Enron
crash, energy trading was THE business, both necessary and big. Money was made
with or without assets - or so it seemed. Trading floors were kitted out by the
dozen and fresh graduates joined by the herd. It was trading with a capital T.
But when the crooked E of "Energy Trading" fell, the capital T too became shaky.

The
capital T shrank along with downgrades of credit ratings, loss of confidence,
and hurried departure of American power-trading companies from Europe. The notoriety
of round-trip power trades to pump up the volume along with the exodus of the
larger power players have redefined what is meant by energy trading, a necessary
but no longer a big part of the utility business.

The definition of energy
trading on the web site of Allegheny Energy, Hagerstown, Md. could not be more
straightforward: "the buying and selling of energy contracts in the wholesale
markets with the objective of generating profits on or from the exposure to changes
in market prices." Yet, just what does it mean in practice today?

A head
of a European energy broking company says energy trading does not just mean buying
and selling energy anymore, and neither has the "big T" diminished in European
energy markets. If anything, trading is done as much for commercial and risk management
reasons as purely for trading's sake. He observes, however, a more measured approach
to trading, that is, not just speculation. Despite the noticeable decline in trading
activity in the last twelve months, he sees the current period as a necessary
part of the cycle. In other words, the trading business will become stronger now
that companies are putting proper risk management systems in place. "When America
sneezes, Europe 'sometimes' catches a cold. We do feel it here, but the European
energy companies have taken up the strife for transparency spearheaded by the
Americans who have now left."

Fred Cohen, Global Energy Risk Management
Leader at PriceWaterhouse Coopers in New York, likens the big T to a more aggressive
approach to market making and taking on larger risk positions than the little
T it has become. "Trading with a small t implies mitigating risk or hedging. Initially
many energy companies looked at trading as a business in itself, a separate profit
centre. Increasingly, such companies are realising the need to integrate it with
the rest of the business under one overall strategy of risk transfer and risk
mitigation."

From big T to no T

Only a few remaining A-rated energy
trading companies (table 1) like Entergy-Koch Trading and Sempra Energy can afford
to stay in energy trading with a capital T. The mix of Entergy-Koch's trading
business is half speculative and half customer-driven. Almost everyone else has
decided to scale down their trading operations, or at least, "trade around their
assets."

In the smaller T category are those companies that have announced
a scaling back of trading. As one of the earlier proponents of "trading around
assets," Duke Energy has also had to reduce staff and scale back because of reduced
liquidity and lower volatility. "The main focus is on assets, though it [energy
trading] will leverage arbitrage and speculative opportunities for the company,"
explains Stephen Morriseau, spokesperson for Duke Energy International.

Another
term for "trading around assets" is Innogy's "asset-backed trading." According
to Brian Senior, managing director, Innogy, Swindon, UK, asset-backed trading
does not mean that assets come first or indeed that trading comes first. Rather,
it's about a partnership between trading skills and asset management skills -
and it is this partnership that will be a critical driver of value in the future.
It's about placing the risk where it can be best managed: market risk with the
traders as they know and understand the markets and asset risks with the asset
owners/operators as they know the limits of the asset.

Senior suggests that
the future will be towards balanced portfolios via vertical or virtual integration
(an asset based portfolio). "By virtue of owning an asset, you will have a position
in market. This 'market' position needs to be managed - and traders know the market
and the asset risk also has to be managed."

For A minus rated PPM Energy,
Portland, Oregon whose portfolio includes wind power, gas-fired plant, and gas
storage facilities, "trading has to happen because we're never in balance 100%
of the time," says spokesperson Jan Johnson. PPM Energy changed its name from
Pacificorp Power Marketing in January 2003 because the old name did not distinguish
itself clearly from its regulated sister utility Pacificorp. In addition, their
business is not just the marketing of power, as they have entered the gas storage
and hub services business as well as the renewable generation development business.

Companies that have decided to get out altogether fall in the "no T" category.
Aquila is one of the larger energy traders who have decided to exit trading and
return to its utility roots. Having sold all its gas assets in pipelines and storage
facilities, it is now trying to sell its power plants save those which are used
to serve its regulated customers. There will still be some trading, but only to
balance out the supply and demand. Aquila' spokesperson Al Butkus says they do
not think this is a temporary phenomenon but one which will take 4 to 5 years
to work out. In fact, Aquila doesn't see a reasonable move on deregulation with
the development of Regional Transmission Organisations (RTO) and regional markets
before the year 2015. By end of January 2003, Aquila has already shed 1,800 of
its workforce.

Energy traders and accountability

Why has energy
trading become a controversial business? Soli Forouzan, President, Mind Span Inc,
a Houston-based independent energy risk management and asset optimization consultancy
reasons as follows. One problem with energy trading in the US is that there is
no certification or qualification required to be considered a trader. As such,
energy trading is not tightly regulated like the financial markets, where brokers
or insurance salespeople need to be licensed. Anybody can call himself an energy
trader. In his experience, many "traders" cannot or do not maintain accurate "books"
measuring their risk and profits.

Commodity trading books are much harder
to track because trades are not standardised. Take the unlimited full requirements
contract for example. When a trader says he will supply all the power a customer
needs, he is taking on a huge volume exposure (risk) for his company, and yet
many companies do not quantify the volume or the profit risk of such trades accurately.

Forouzan defines a trader as one that has profit and loss responsibility
with a trading book which isolates ALL revenues, expenses, and risks attributable
to him or her. He is not an order taker or someone who does not have a separate
book. In the case of collective books, where many people trade in but aren't individually
accountable for, the manager in charge of the overall book profits and risks is
more of a trader even though he may not necessarily be executing any transactions
himself.

Within the energy industry the above problems are magnified by
the need for actual (physical) deliveries. Physical delivery of commodities such
as energy is a messy business, involving numerous instances of over or under delivery,
non-delivery and too many fees and tariffs. While this may be ignored for forward
delivery periods, once a commodity, like power, starts flowing, there will often
be delivery issues, whose benefits or costs are not reflected in a trader's books.

Most trading systems oversimplify what really happens during delivery.
This is not a problem in the financial industry, where products are standardised
and execution surprises are few. In the energy industry however, most accounting
systems fail to properly allocate transmission or other physical costs and fees
incurred in delivering the product. The typical accounting system is incapable
of tracking the actual charges and allocating them to the individual trader. These
are not negligible either. For that matter, most companies do not charge individual
traders for the capital they use or the credit risk they create, thus giving traders
no incentive to pick more credit-worthy counterparties or to consider the capital
requirements of their trades.

Trading vs speculating around assets

Forouzan distinguishes between "trading" and "trading around assets", as well
as "trading around assets" and "speculating around assets" (tables 2 and 3). Forouzan
advises energy companies that still profess to trade around their assets to keep
two sets of books, one for speculative trades and one for assets.

The asset
book is operationally driven, and impacted by how the asset is behaving every
day. There needs to be a way to instantly update the asset position through a
constant feedback loop with operations. The asset book is typically delta-neutral
and is used to track the effectiveness of the trader in monetising the asset's
optionality and to lock in a return on the invested capital. Any unhedged or overhedged
positions should be transferred to the speculative book, allowing managers to
judge their traders on both their ability to manage assets and to speculate on
pricing moves.

For the speculation "spec" book, the trader's position typically
doesn't change (option positions are an exception) unless he trades. For example,
buying a commodity causes a long position and stays long until there's a sell.

In
an asset book, there will be a spread position (input fuel, output power) and
a volatility exposure. For example, the trader is long volatility because he has
an option to run the power plant. And the position is constantly changing due
to the exotic nature of these options and the operational considerations which
can change at any moment.

As owner of these options, which come "embedded"
in assets, the trader should have limited downside risk but unlimited upside.
In other words, the trader should not make less money than what he has locked
in, which is why companies are joining the "trade around assets" chorus.

But
managing to capture the upside is not trivial. It requires different tools (trading
systems) and a different mental attitude. It requires thoughtful trades which
take into account all operational and legal angles of managing the asset.

"When
you truly trade around assets, you have to think about future moves like a chess
game, where you think three steps ahead. For example, you have to decide on whether
to use your emissions rights today or save them for the next month." Forouzan
concludes, "When you speculate around assets, you move in and out of positions
quickly and frequently. You're simply watching the flow of trades out there."

The
future of energy trading

"Many utilities got seduced by the sexiness of
trading as an end in itself and as a means to make lots of money," observes Douglas
Swinden, Managing Director, Highmoor Consulting, Bury St. Edmunds, UK, an independent
energy advisor. While some energy traders did make a lot of money (some also lost
a lot of money), there is now a realisation that trading should primarily have
been a means to manage risk, which for the great majority of utility businesses
should have meant risk minimisation. "It was only the naive optimists who believed
that the liquidity in traded power markets could ever reach the liquidities experienced
in the mature financial markets."

While energy companies are returning
to their utility roots, financial institutions with better credit are gearing
up to trade energy. PriceWaterhouse Cooper's Cohen questions how they will define
their roles and whether there will be enough participation to be sustainable after
some had entered the market and then diminished their roles or exited completely.
"There still needs to be a clear linkage to underlying physicals. You won't expect
the kind of multiple trade volumes over the amount of energy to be delivered in
other commodity markets," he says.

Meanwhile, Aquila's Butkus expects the
large oil companies to move into gas and power trading because they have the credit
rating and the physical trading and risk management experience. When that time
comes, energy trading may have a chance to return to a capital T.